Bernard Hickey argues the Reserve Bank and Bill English should stop turning a blind eye to the breach of the bank's 1-3% inflation target, and actually have a debate about widening or lowering the target

Short headline: 
A 'good' deflation debate

By Bernard Hickey

Let's debate 'good' deflation.

On the face of it, there's everything to love to about deflation and nothing to hate.

From a consumer point of view, falling prices seem unequivocally good, particularly if the shopper is a worker and a homeowner and their wages and house prices are rising at the same time.

It means that any income growth is more powerful and the wealth in their homes can be leveraged up for even more consumption or investment because consumer price deflation is usually combined with falling interest rates.

It seems like the best of all worlds and that's exactly how a lot of Aucklanders are feeling right now. An extra 70,300 jobs have been created in the region in the last two years, meaning 782,200 were working in the December quarter or 66% of the working age population. Median household after-tax income rose 3.6% over the last two years to NZ$1,537 a week.

Auckland's median house price rose by NZ$140,000 over those two years to NZ$675,000, meaning the equity gains for the median household were around NZ$1,346 per week, or rose almost as much per week as total take-home pay.

Meanwhile, prices for a lot of the things homeowners with fresh equity can buy have also fallen. The price of 'tradeable' goods and services, which means imported items and those where the prices are set on international markets, fell 2.3% over the last two years to levels seen back in mid 2010. That means cheaper clothes, shoes, overseas holidays, cars, double cab utes and imported food.

So far so good. But the picture isn't quite as bright for those on below median wages who got below median wage growth and who don't own a home. Their costs are rising much faster than their wages. The weekly rent on a three bedroom house in Auckland rose 13.5% to NZ$602/week in the last two years, more than triple the rate of wage growth. So deflation is good for some workers and consumers, depending on who they are and what they spend their money on.

Deflation is also no fun at all for businesses and Governments. Employers are still having to increase wages of competition in the job market and falling unemployment, but they're often have to cut their prices if they are competing with cheaper imports. Deflation usually squeezes profit margins if companies can't find even cheaper ways to do things, which might mean cutting staff or switching to cheaper imported costs.

Governments struggle to grow their tax revenues when prices stop rising, particularly for GST and corporate taxes. Finance Minister Bill English has warned repeatedly that low inflation is making it increasingly difficult for the Government to reach its surplus target this year. Prices actually fell 0.2% in the December quarter and the Reserve Bank is forecasting annual inflation in the March quarter of 0.0%.

This is where the deflation debate starts to get controversial. The Reserve Bank Governor, Graeme Wheeler, has agreed with Mr English in his Policy Targets Agreement to target inflation of around 2% and within a range of 1-3%. Annual inflation has been below 2% for almost four years and will have been at or below 1% for a year and a half by March next year, according to the Reserve Bank's own forecasts.

Mr Wheeler himself has said he is 'looking through' the 0.9% cut in the annual inflation rate because of the slump in the oil price last year and he remains confident inflation is heading back towards 2%, even though his own forecasts only show it rising as high as 1.7% by March 2017.

Prime Minister John Key has said he will 'cut the Reserve Bank some slack' on the current target and referred to the bank's efforts to hit 2% as like a super-tanker that takes some time to turn. Mr English also seems relatively relaxed about the apparent breach of the target if not the deflation itself, saying New Zealand had a 'good type' of deflation.

Unlike Japan and Europe where slow to no GDP growth and high unemployment dragged on prices and wages, New Zealand had strong GDP growth and low inflation caused by a high currency and falling oil prices, he has said.

"I don't think we've got to worry," the minister who signed the PTA said in a recent speech in Auckland when asked about the risks of deflation. "It's not a negative for us to have low inflation," he said.

This does beg the question though: has the current agreement with the Reserve Bank become asymmetrical? Do Mr Wheeler and Mr English care a lot more about inflation over 3% than inflation under 1%? Can some deflation be ''good" deflation vs 'bad' deflation, and how are we to know the difference?

So far the Reserve Bank and the Government have taken the 'good' deflation route to explain and justify the current deflation, or simply deny it will last very long. This fuzzy decision making within the PTA is having real world consequences. The New Zealand dollar is much higher than it would be if the Reserve Bank cut interest rates in response to deflation, as almost all other central banks in the developed world have done so far this year.

The end result of running a high Official Cash Rate in defiance of deflation is the continued stagnation of the exporting part of the economy, which directly conflicts with one of the Government's major targets — to lift the export share of GDP to 40% by 2025. That share fell to 28.7% last year from 32.7% in 2008. It's why regional New Zealand has struggled over the last seven years relative to Auckland and Christchurch, which are much more focused on the domestic services industries such as real estate, construction and retailing.

Deciding to turn a blind eye to deflation may actually turn out to be the right thing to do. The Bank For International Settlements, which is the central bankers' bank, argued this month that deflation doesn't necessarily signal an underlying weakness in economic demand. It could be a sign of a 'supply shock' whereby a new technology or resource discovery is producing a lot more supply, thus driving down prices. Cutting interest rates and printing money to solve a shortage of demand that did not exist would be like flogging a dead horse, or more likely, blowing hot air into an asset price bubble that could eventually burst.

So running a lopsided monetary policy that treats deflation differently from high inflation may avoid blowing up a bubble. But that's not a debate we're having. The Reserve Bank is simply denying deflation is more than a passing phase and the Government is turning a blind eye to the breach.

If we had a real debate it may mean we actually changed the PTA to widen or lower the target, or talk about the possibility of 'good' deflation caused by supply shocks. We should have that debate because deflation, high interest rates and an over-valued currency have real consequences for renters, beneficiaries, exporters, the Government's revenues and the regions.


A version of this article was also published in the Herald on Sunday. It is here with permission.